Friday, September 26, 2008

"It seems likely that our economy will fall into recession if interest rates are not reduced significantly over the next 12-18 months"

-- Rory Robertson, Macquarie's interest rate strategist, who usually has a good reading. Here is his excellent note:

**Most global economic and financial variables still are trending in the wrong direction. After last week's massive shock to the global financial system - with the sudden failure of a couple of US household names (AIG and Lehmans) prompting increased "risk aversion" everywhere - there's obviously an increased chance that the RBA's 7 October cut now will be 50bp (to 6.5%) rather than just 25bp.

**The case for the larger 50bp RBA cut simply is that the outlook for local and global growth continues to darken - and (so) the outlook for lower inflation continues to brighten - as the global credit crunch intensifies...As I have highlighted here regularly over recent months, the basic story across the developed world remains disturbing: credit growth, consumption growth and employment growth all are trending towards weakness, gradually pushing up unemployment.

**Pretty well everywhere, highly geared firms and households are "hunkering down", trying to economise on spending, sell "non core" assets, pay back debt and build cash reserves to survive any worst-case credit-crunch scenario. Weak (highly geared) balance sheets are being forced to sell assets to stronger balance sheets. The problem is that all this "hunkering down" reinforces the trend towards economic weakness. And capital-constrained lenders generally are responding with tighter credit standards, causing further stresses, and so on.

**With most intermediary lending rates in Australia at 9% or higher, RBA policy remains extremely tight. At the same time, the global credit crunch continues to intensify, and solid local firms increasingly are struggling to get funding for expansion ("credit rationing") as the banking system finds it more difficult to fund its existing loans/balance sheet.

**The recent drops in the A$ and fuel prices are supportive of growth in Australia, but - given the clear weakening of household demand over 2008 so far - it seems likely that our economy will fall into recession if interest rates are not reduced significantly over the next 12-18 months.

**The list of OECD economies hovering in or near recession is growing: the US, the UK, Japan, Italy, Canada, Germany, France, Denmark, Ireland, Iceland, New Zealand, Portugal, Spain and The Netherlands (others?). Growth already has stalled across the big G7 economies. Sooner or later, the NBER will confirm that the US economy is indeed in "recession".

Meanwhile, the biggest fast-growing developing economies - read China - also are slowing, but the poor quality of the (mostly year-to) activity data make it hard to know by how much. Probably more than most observers currently realise.

**Central banks generally have tried to keep their "liquidity provision" function separate from their "monetary policy" function. Some see this distinction as artificial and unhelpful: indeed, one might argue that in not cutting rates - the policy action most households and businesses most understand - in recent months, the Fed, the BOE, the ECB and others have been fighting the developing crisis with "one hand tied behind their backs".

**If things continue to go badly, as well they might, and the global credit crunch continues to drag down global growth - with global inflation pressures continuing to subside (see attached) - sizeable rate cuts will be the next course of action pursued by the major central banks.

**My guess remains that, over the next 12-18 months, we'll see the Fed cut to 1% or lower, the Bank of Canada cut to 2% or lower, and the ECB and BOE cut to 3% or lower; meanwhile the RBA and RBNZ still look set to cut to 5% or so (from policy rates at present, respectively, of 2%, 3%, 4.25%, 5%, 7% and 7.5%).

**It is the job of central banks and governments to do what they can to limit the severity of recessions. And the Fed and the US Treasury have been working overtime - every weekend recently! - to limit the damage from the intensifying credit crunch.

**We've recently seen the US Government's takeover of Fannie and Freddie, an $85b loan to AIG, Lehmans let go, Merrills sold to BOA, Goldman Sachs and Morgan Stanley made "banks", money-market funds guaranteed, and new restrictions on short-selling. (What have I missed?)

**On US Treasury Secretary Paulson's proposed $700b (5% of GDP) package to buy "troubled" (mostly) mortgage-related assets, I'm in the camp that says "do something now", please. The US/global bus is hurtling backwards down the hill towards a ravine, yet many politicians seem to be arguing about the colour of the rocks/logs that need to be put under tyres NOW to avert disaster.

**For what it's worth, my sense is that Chairman Bernanke and Secretary Paulson - and their large teams of highly qualified officials - are smart and determined to do what they can to hold the system together. So give them the cash and let them keep busy!

Chairman Bernanke clearly has all the goodwill in the world towards US taxpayers and the US economy overall. And that's probably true of Secretary Paulson as well, given that his net worth reportedly is way in excess of US$100m - that is, he doesn't actually need his current job, or the stresses that must go with it.

**Assuming something like the proposed US$700b package passes Congress in the coming week, the main debate now seems to be about the "right" prices at which officials should buy these troubled assets - at the current "market"/"firesale"/"distressed" prices or at the "underlying"/"inherent"/"hold-to-maturity" prices.

**In any case, won't market prices naturally shift up a bit when a gorilla appears on the scene with US$700b to spend? If analysis by the Fed, the BIS and the RBA is right (see yesterday's note), there is potential for a win-win outcome for US taxpayers and banks at a range of prices between these two still-shifting marks. Warren Buffett reckons US taxpayers will make big capital gains - not losses - on the proposed US$700b trade.

**Officials naturally will be hoping that the first few US$10b purchases by the US Treasury will spark further purchases by global real-money funds (ungeared players), who also recognise the underlying value in the damaged-but-still substantial mortgage-related cashflows but so far have - rightfully! - been scared of the mark-to-market risks.

**Early this month, the RBA - for the first time in over six years - cut its cash rate, by 25bp to 7%; major lenders immediately reduced their headline mortgage rates by 25bp, to about 9.35%. And until recently, we looked to be set for an "action replay" of that 25bp-rate-cut process after the RBA's next meeting, on 7 October.

**Over recent weeks, however, growing global stresses have seen Australia's three-month bank-bill rate - a key indicator of bank and business funding costs - jump sharply, from about 7.2% in the first week of September to about 7.4% this week (7.43% today).

This has put a big question mark beside the idea that major lenders will follow any 25bp cut by the RBA. The RBA may be forced to cut harder to achieve the desired effect on intermediary lending rates.

**Looking way down the track again, my guess remains that RBA policymakers over the next 12-18 months will decide - as unemployment rises beyond 5% and inflation pressures subside - that policy again should be mildly restrictive, as it was last July, rather than extremely restrictive, as now. That would imply a reduction in headline mortgage rates to about 8%, from 9.3% today, and similar reductions in other lending rates.

**In that case, the main question will be whether the RBA's cash rate needs to be reduced by a further (say) 1.25pp to 5.75%, or by (say) 2.25pp to 5%, or lower.

That latter scenario - aggressive easing - may well be required if longer-term funding markets remain difficult or deteriorate (as they have recently): large drops in average lending rates will require much-larger reductions in the RBA's cash rate.

**Importantly, the RBA cares much more about average lending rates than it cares about its cash rate - the latter simply is the tool used to deliver the former.

The RBA eventually will reduce its cash rate by whatever amount is required to reduce average lending rates to the level policymakers see as being required to support the economy as inflation pressures subside.

Clearly, much will depend on future developments - good or bad - in global credit markets. Again, the good news is that, in a pinch, the RBA has a big 7pp to work with.

**Eventually, the cyclical downtrend in the global economy will bottom and recovery will emerge. But the process probably will be very painful, and perhaps several years in the making. In the meantime, most big western economies will need to deal with tight credit, weak spending and rising unemployment. Central banks in these economies - once they judge that inflation risks have subsided - probably will find themselves kept busy delivering rate cuts.

**My guess that the RBA's cash rate will be reduced to 5% by the end of next year is the most-aggressive forecast in the market. Time will tell if I got too carried away, or wasn't aggressive enough. Keep those end-2009 forecasts in your mind - 1%, 2%, 3% and 5%. Right now, it doesn't take too much imagining to think rates might end up even lower.